The Fed Controls Interest Rates... For Now

by: Paul Nouri, CFP

In an article I wrote recently, I made the argument that in contrast to what the media and analysts have been opining, the stock market has not been increasing at a 36% annualized rate since November because of good and improving economic data and earnings, but more likely as a result of continued accommodation from the Federal Reserve bank.

Most pundits, even the cautious ones, will argue that as long as the Federal Reserve remains accommodative, interest rates will remain at record lows and stocks will climb to historical highs. In other words, you win no matter what, all you have to do is play. Can that be right? Unlikely.

In 1975, Milton Friedman wrote a book entitled "There's No Such Thing As A Free Lunch". Considering the current Federal Reserve runs monetary policy out of an economics 101 textbook, you might think that the voting members would have a grasp of this idea. Instead, they throw caution to the wind. In their minds, no matter the risks, current monetary policy is achieving the greater good.

The problem is how the risks of excessively dovish monetary policy are contextualized. Currently, the big question among the financial news media and pundits is whether or not the Federal Reserve will rein in monetary policy once the economy is "fully healed". That point is almost irrelevant in my opinion as it assumes that the Federal Reserve ever has an intention to unwind these least among the current board of voting governors. As I'm writing this, a headline came across the wire from a non voting member of The Fed that "FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5% to 5.5%". The more likely scenario is that bonds that The Fed has been buying in order to maintain low interest rates will be held to maturity. So what is the real risk of keeping interest rates so low?

To start, I want to mention that earlier this week, members of the BRICS countries (Brazil, Russia, India, China & South Africa) met at only their fifth annual conference. The association of these emerging economies began in 2009 as a way to co-operate with one another on currencies and economies. We can imagine that these countries felt the need to form a coalition because while their collective GDP is almost equal to the United States and greater than the Euro region, little consideration is given to them when central bank policy decisions are made in developed economies.

For instance, when the largest economies in the world decide to lower interest rates to historic lows and initiate bond buying programs to create an environment with almost zero interest, their currencies are weakened, making their exports look more attractive than that of their counterparts. This strategy can cause isolationism, but the members of The Fed don't see this. The Fed thinks they're doing everyone in the world a favor. In fact, in a recent meeting in London, The Fed Chairman had this to say: "Because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not 'beggar-thy-neighbor' but rather are positive-sum, 'enrich-thy-neighbor' actions," he said.

Turning our attention back to The Fed's ability to control interest rates: simply put, it is limited. The Federal Reserve sets a target rate and engages in different practices to attain that rate. Historically, The Fed has been able to control the level and direction of interest rates, however, as varied regions throughout the world struggle for economic growth, it risks losing that control. Japan has recently taken a more accommodative stance, a move that automobile makers in the U.S. are saying makes them less competitive compared to Japanese auto makers.

Collectively, the BRICS nations have a debt to GDP ratio of around 32% compared to the U.S. at 100%. Additionally, the BRICS nations are growing GDP around 5% annually, while the U.S. is at 1.6%. The emergence of this economy, which is collectively as large as ours, raises the risk of investors' ability to look outside the United States for yield. In their meeting this week, the BRICS pledged to put together a $100 Billion fund to combat currency crises that negatively effect their economy. Moves similar to this should balance the power between the U.S. and other economies around the world and give pause to current monetary policy, but we doubt that it will. It could instead lead the U.S. on a path towards isolationism, where we take it for granted that our policies are all that matter.

In conclusion, the path that The Federal Reserve is on right now is a dangerous one that opens the door for significant tail risk. While I'm not arguing that it is likely that money will flow out of the U.S. causing stagflation within, I am putting it out there as a real possibility. If The Fed loses control of interest rates, investor confidence will plummet, loans will be unaffordable and the economy will be stuck in a Fed induced crisis. Moreover, state and federal budgets will spiral out of control as they have relied on low interest rates of late to help fund record deficits (though low rates have effectively increased pension liabilities). To avoid a scenario like the one described, the answer is simply for The Fed to relay to the markets that at some point, rates will actually increase. A speculation induced rally should not make The Fed proud (they have gone so far as to announce that increased stock prices are the primary positive externality of low rates), it should give it pause.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.